Understanding gears in investment vehicle

Do you know that investment products are called Investment Vehicles as well? The reason is that vehicles takes you from Point A to Point B; so as Investment products take you from where you are today to  where you want to be tomorrow, in terms of your financial goals. They are meant to make sure that you reach your financial destination or in other words you reach your targeted goals. For example, let us assume that your daughter is 2 years old and you have to plan for her marriage at the age of 22. Now Point A is where you are today and Point B is where you have to reach after 20 years. Your target is the amount that you want to accumulate so that you can marry her. So you need a vehicle which can take you from today to tomorrow.

Now at times, your destination is very nearby and at times very far away. Now this article will make you understand what kind of investment products are well suited for different needs that you have for your financial goals.

To understand it in a much better manner, think of Gears in your vehicle. There are 4-5 gears in vehicle and each gear is meant for a specific speed. When your destination is very nearby, we use 1st or the 2nd gear and our speed is slow. But when our destination is quite far, we are in high speed gears like 4th and the 5th.

We will try to understand it by analogy

Just imagine a situation where you have to go to nearby grocery shop. Would you take go for an air journey for this purpose? Sound funny! Let us change the example; you have to go to Canada for a vacation. Would you go walking or take cycle for this purpose. Sound irritating!

Now in Financial Investment products, there are mainly two types of Investment vehicles. One is Debt and another is Equity. Debt is where we get returns in the forms of Interest like Fixed Deposit, PPF, Post Office MIS etc. Equity is about ownership of companies/Businesses and sharing their profits and losses through Share holdings.

Ownership VS Lending in investments

When we plan for long term investment, the return on investment can be higher as you have the road and time to accelerate and decelerate. This is also required as much more money will also be required for longer term goals like retirement. Also, one needs to contend with inflation, which will have a major impact over a long period. You have to make sure that the returns on investments are greater than the rate of inflation. This can happen only when you invest your money in Ownership Assets. Ownership assets have short term fluctuations but in long haul, they beat inflation and create wealth. Long term financial investment which beat inflation is Equity and it is equity which creates wealth in the long term. When we talk of equity, we would like to clarify that we don’t advocate people to invest in equity directly unless they have in-depth knowledge of markets. For people who are not specialists, it is better we leave to professionals and invest in Equity Mutual Funds.

Now Debt is a slow speed gear where returns are less and when you take inflation into consideration, the returns are almost negligible or at times negative. We should invest in Debt mainly when our financial target is nearby. For example, if you need to marry your daughter in next 2-3 years, you should invest in Debt products. They are good investment as they will protect the capital and there is no downside risk in short run.

But if your daughter is 2 years old and you need to plan for her marriage after 20 years, would you take debt? It is something like driving your vehicle on first and second gear. But do you think you would do that if you were to travel long distance like from Mumbai to Delhi. No, you will not. You will have to shift to higher gears, for that journey. The chances of meeting with accident are there but for that you need to know how to drive well and you take calculated risk and if you don’t take the risk, the risk of going slow is much higher. This is what we should do in our investment as well. We should invest in Equities when your financial target is far off.

Equities have always delivered returns in long run but they are risky in short run. In last 20 years, Sensex have delivered over 17% return p.a. that means your Rs. 1 lac investment in 1990 is worth Rs. 23 lacs today. In last 30 years sensex have delivered over 19% p.a. growth which converts your Rs. 1 lac investment in 1980 to Rs. 1.8 cr today. That is the power of Equity.

How we forgot reverse gear??

Indians are one of the biggest savers in the world but what about investment. There is huge amount laying in our saving bank account or for investment we use insurance endowment plans – these are examples of driving your vehicle in reverse gear. You are not moving ahead but going back every passing year due to investor’s biggest enemy that is INFLATION.

As legendary investor Warren Buffett quoted “Investor has to do very little things right as long as he avoids Big Mistakes.”

Practically, Equity should be for Long term and Debt for short term, but investor does the opposite, Equity for short term and debt for long. Equity investments are best when you invest through SIPs in a well diversified Equity oriented Mutual Fund. For Debt, one can opt for FDs in case tax liability is low and if tax liability is high, one can go for Fixed Maturity Plans as well.